A markup interpretation of optimal rules for irreversible investment
Author(s)Dixit, Avinash K.; Pindyck, Robert S.; Sødal, Sigbjørn
Massachusetts Institute of Technology. Center for Energy and Environmental Policy Research.
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We re-examine the basic investment problem of deciding when to incur a sunk cost to obtain a stochastically fluctuating benefit. The optimal investment rule satisfies a trade-off between a larger versus a later net benefit; we show that this trade-off is closely analogous to the standard trade-off for the pricing decision of a firm that faces a downward sloping demand curve. We reinterpret the optimal investment rule as a markup formula involving an elasticity that has exactly the same form as the formula for a firm's optimal markup of price over marginal cost. This is illustrated with several examples.
MIT Center for Energy and Environmental Policy Research
MIT-CEEPR (Series) ; 97-002WP.